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Investing in Bad News- Is it worth being contrarian cover

Investing in Bad News: Is it Worth Being Contrarian?

Investing in Bad News: Is it Worth Being Contrarian?

“To succeed as a contrarian you must recognize what the crowd believes, have concrete justification for why the majority is wrong, and have the patience and conviction to stick with what is, by definition, an unpopular bet.” -Whitney Tilson

Hello Readers. Contrarian investing in one popular strategy which has definitely build wealth for all those who have followed this strategy strictly. However, being a contrarian is easier said than done. 

For today’s article, we will be exploring the strategy of investing in bad news, which also happens to be a common investing strategy used by most retail investors when dabbling in the stock markets.

The topics we shall be exploring today are as follows:

  1. What is bad news investing?
  2. Can bad news investing go wrong? If so, how?
  3. Cockroach Theory
  4. A thinking model for investing during bad news
  5. Conclusions

It’s going to be a very interesting article, especially in the dynamic market scenarios like that of late. Therefore, make sure that you read the article till the end so that you do not miss out any important concept. Let’s get started.

1. What is bad news investing?

Bad new investing is a simple strategy followed by investing across experience level where they buy stocks of companies that have been beaten down by negative sentiment in the media.

Most investors buy such companies when they believe that the news surrounding the company is only temporary in nature and the company can resume its past stock levels in time.

This is a strategy that was espoused by Benjamin Graham and has been followed by many of the great investors ever since including Warren Buffett, Peter Lynch, Carl Icahn, Mohnish Pabrai among others.

2. Can Bad News investing go wrong? If so, how?

Like all investing strategies, this one too is not without flaws. The strategy if not employed properly can result in losses or worse in permanent loss of capital. 

Although it takes courage to go against the herd and a lot of the times it pays handsomely to do so. But, when deciding to invest in a stock surrounded by negative sentiment, it is important to realize that sometimes the stock would have fallen in price because it deserved to be priced lower.

A lot of times investors (including myself) tend to anchor to the price a stock was trading prior to the emergence of the bad news that price that is available at a significant discount to that price may seem to a buying opportunity (Also read- Value Traps).

A lot of times we tend not to redo our homework and perform the valuation for the company factoring in the effect of the news that has emerged instead we buy the stock based on the valuation we may have performed months before to make a buying decision.

3. Cockroach theory, Murphy’s law, and probabilistic thinking

Learning from my experience, a conservative investor would do well to keep these two thumb rules in mind when analyzing investment opportunities arising out of bad news.

The Cockroach Theory is a market theory that states that when a bad news is revealed about a company there is usually many more around the corner. This comes from the common belief that when a cockroach is spotted in a household, it is likely that there are many more in the vicinity.

Murphy’s law is pretty simple and straightforward compared to the former, it posits that whatever can go wrong, will go wrong.

Since investing is an imperfect art and it is impossible to state anything with certainty, investors would do well to think probabilistically to ascertain possibilities of thing going more wrong with the company.

For example, If a company’s management has been accused of fraud, then in all likelihood it is possible that the fraud has been happening for years and not a one-time thing.

On the other hand a factory being shut down due to worker protests could be a major event but the probability of such events impacting a major manufacturing company for the long term is pretty low since managers usually try to solve such issues by entering into contractual agreements with trade unions on new terms of operations and not just a non-written understanding of sorts.

4. A thinking model for investing during bad news

Many a time Warren Buffett has made an compared his investing style to Ted William’s baseball style in ‘The Science of Hitting’. Ted, famously proclaimed that he would wait for a fat pitch before attempting to hit a shot and ignore everything else.

We believe this concept is best explained in his own words, kindly refer to the excerpt below

the science of hitting

Now building on his concept, let’s try to develop a map of bad news pitches we would receive as an investor.

From a logical perspective, the bad news could be of two types – it could be a temporary or a permanent problem while the impact this could have on the price could be large or small.

Taking different combinations of these would give us four possibilities as shown in the graphic below.

possibilities bad news-min

The sweet spot for us as investors would be to hit only those pitches that come at us from quadrant one since this is likely to be the situation where the market has overreacted to a minor news and has subsequently mispriced the underlying stock.

An investor could then proceed to add the stock into their portfolio all the while averaging down if the price of the stock were to drop below the initial entry price.

New to stocks? Here is an amazing online course for the beginners- How to pick winning stocks? Enroll now and start your journey in the exciting world of the stock market today!!

5. Conclusion

Although Bad news could provide an amazing opportunity for investors to add stocks to their portfolios, it can cause an equally potent damage to the portfolio in the event the buying decision turns out to be a bad one. It is therefore imperative for every investor to take time to think about the new realities the company is faced with before buying its stock.

We believe a prudent investor using a well defined rational process to invest in these situations should be rewarded handsomely over time. Happy Investing…!!

what is working capital cover

What is Working Capital? Definition, Importance & More.

What is Working Capital? Definition, Importance & More.

Hello Readers. One of the most important factors to check while analyzing a company before making an investment decision is its working capital.

In simple words, working capital can be defined as the funds available to a firm to finance its regular operations like day to day business activities. Nonetheless, the noteworthiness of working capital is way more than what most people think. 

In today’s article, we will be focusing on the importance of working capital management and how it could be studied to get a deeper insight into the companies we are researching for potential investments. 

Here are the topics that we’ll cover in this post.

  1. What is working capital?
  2. Why is working capital important?
  3. What factors affect the working capital of a company?
  4. When Negative net working capital is actually positive.
  5. Conclusions

Overall, it’s going to a very educational post. Therefore, please read this article till the very end. Let’s get started.

1. What is working capital?

To define the term in the simplest words, working capital is essentially the funds that have been allocated for day to day operations of the firm for the current financial year. These funds need not entirely be held in cash but could also include any asset or liability from which a cash transaction could be expected. This could include account tradables, cash in hand, account payables and short-term borrowing and loans.

The most commonly used formula for working capital is given by the following,

Net Working Capital = Current Assets – Current Liabilities

When an investor wants to look only at the operating level of a company he may prefer to use the following formula for working capital.

Operating Working Capital = Cash + Inventory + Accounts Receivables – Accounts Payables

Please note that the operating working capital excludes the short-term interest and loan payments a company may have to incur in a financial year.

2. Why is working capital important?

Conventionally, the working capital is used as a measure of a company’s liquidity. Since it is calculated on the basis of accounts receivable/payable, cash, borrowing and payments, the working capital of a company could tell us a ton about the management’s approach and commitment to inventory management, debt management, revenue collection, and payments to suppliers.

A positive working capital would imply that a company has got a good control over its transactions and is able to collect and make payments with a large degree of freedom.

A negative working capital, on the other hand, would normally imply the opposite.

3. What factors affect the working capital of a company?

Although working capital is studied to get an understanding of the management and the general thumb rule that positive working capital is always better than negative working capital works most of the times in investing. We, at Trade Brains, believe that investors could get access to more opportunities if they were to take a more holistic approach to study working capital.

Since a company is always involved in a particular business, it is, therefore, logical to assume that all the short/long term factors affecting the industry will determine how managers conduct their operations and hence the working capital. In some industries, managers can offset the risk in operations by choosing a favorable business model. Depending on the kind of model they choose to operate could also determine the working capital of the company.

On a broad level, the list of factors that can affect the working capital of a company are as below (note that this is not exhaustive but may be used as a guide)

  • Nature and type of business
  • Type of Industry
  • Factors of production and their availability
  • Competition
  • Price levels and inflation
  • Production Cycle Time
  • Credit Policy and agreements with suppliers and customers
  • Growth and Expansion strategies
  • Working capital cycle

A more quantitative approach to analyzing working capital would be through a basic ratio analysis. Below are the most useful metrics used by fundamental investors.

4. When Negative net working capital is not so negative!

Imagine a newspaper printing and distribution company with around 2,000 customers in a city. When a customer signs up for a subscription for 1 year, he/she may have to pay the amount up front for the period for which the service is provided. Assume that the subscription cost for one year is ₹1,000, this implies that the company will receive ₹20,00,000 in advance payment. This amount is recorded under accounts payables portion of the balance sheet. Assume that the company holds another ₹8,00,000 in cash and an inventory worth ₹2,00,000.  The net working capital of the company can then be computed to be -₹10,00,000.

In the above example, it can be noticed that even though the working capital happens to be negative the business model of the company allows the company to receive its cash well in advance. This cash could then be ploughed back into the business as investments into new equipment or into marketing to expand its client base.

In general, companies that have high inventory turns and perform a lot of business on a cash basis, such as grocery stores or discount retailers, require very little working capital. These types of businesses raise money every time they open their doors. Because of their advantages, these company can also enter into contracts with vendors and suppliers to lend their products for free for a specified period of time. These partnerships allow the retailers/discounters to keep their cash in hand and employ them elsewhere which trying to sell the products they got through credit. If they are unable to sell them they could just return it back to the vendors before the end of their negotiated period without any cost.

The following sectors are normally observed to operate with a negative working capital.

  • Retail: Due to supplier agreements and high inventory turnover
  • FMCG: Able to leverage their wide brand appeal and customer demand to get retailers to book their products in advance
  • Automobiles: Companies employ “just in time” manufacturing policies to keep efficiency high and inventory at low levels. Also, they normally charge a decent sum as an advance from customers as booking charges.
  • Media: Services are provided only after an upfront subscription fee

5. Conclusions

Although analyzing the working capital and its various components form an essential part of investment research. An investor should always keep in mind to view the company as a business and try to understand the root causes within the business model or the industry which drive the numbers.

Sticking to an individual’s circle of competence may help greatly in this regard which investing in stock markets. Happy Investing!

how to mutal funds make money trade brains

How Do Mutual Funds Make Money?

How Do Mutual Funds Make Money?

Ever seen the “Mutual Funds Sahi Hai!” ads? Have no idea what we are talking about? Check out the ads here!!

We, at Trade Brains, happen to see a lot of these advertisements. In fact, we even love them because although comical and mere advertisements and these ads educate the public about mutual fund investments in a more touching way than what we could ever do.

(Source: Mutual fund Sahi Hai)

But those of you who have seen these ads must have wondered for a long time about how these guys make money? Why give so much wealth away for free? After all, economics says that there are no free lunches, right?

Well, to be honest economics is right. There are no free lunches and mutual funds are not free. This post is aimed to provide a basic insight into answering the above questions. Here are the topics that we’ll cover in this post:

  1. What are mutual funds?
  2. What are the sources of revenue for a mutual fund?
  3. The different costs involved in running a mutual fund.
  4. Industry trends and closing thoughts

Overall, it’s going to be a very interesting post for the mutual fund enthusiasts. Therefore, let’s get started.

1. What are mutual funds?

Mutual funds are investment vehicles managed by professionals that seek to pool investments from many people together before investing them into markets within the financial ecosystem such as equity markets or debt market or a hybrid of both debt and equity. These vehicles are normally managed by professional fund managers or are programmed to follow certain broad indices pertaining to a certain industry or a country.

In general, mutual funds are thought to be best platforms for investors to get the benefits of capital appreciation from the equity markets even if they are not confident to manage their own money in the markets or if they are not able to dedicate time for their own research.

Some retail investors who invest on their own also happen to invest mutual to provide some diversification in their portfolio or reduce the volatility of returns since a lot of the times retail investors tend to have a concentrated portfolio of around 8-20 stocks.

Also read:

2. How Do Mutual Funds Make Money? And what are the sources of revenue for a mutual fund?

The biggest source of revenue for mutual funds is usually the fees that they charge from their investors. This usually comes out in the range of 1.5%-3% of the assets under management. This is commonly known as the expense ratio. Here is the example of the expense ratio for a few popular funds:

expense ratio

However, as of September 2018, it has become legally binding for mutual funds to limit their total expense to 2.25% of the total assets under management. 

References:

The other sources of revenues for a mutual fund come in the form of exit load, front loads, and purchase fees etc. (Also read: 23 Must-Know Mutual fund Terms for Investors.)

3. What are the costs involved in running a mutual fund?

Since most funds hire analysts in research positions a good chunk of the revenues is spent as salary expense for most mutual funds. Other expenses include rent of office and facilities, administrative expenses, payments for research material from data sources etc.

The other major expenses include brokerage fees and transaction costs, costs, investment advisory fees, and marketing & distribution expenses.

4. Current Industry trends

Since this industry is very competitive it can be said that when it comes to profits being the industry tends to follow a bell curve with close to 50% of fund houses making a profit in a year. But lately, the trend has been that some firms also generate profits not from their core operations but also by providing research and analytics to clients based offshore.

Another interesting observation to be made is that fund houses which operate a number of mutual fund schemes tend to have higher profitability than their peers. This is due to the fact that a lot of the core setup required for research and administration is pretty much in place and doesn’t need to be set up from scratch each time a fund house launches a new scheme.

Also read:

Closing Thoughts

Investors in mutual funds could protect their investments if they were to invest in safe fund houses which can generate a decent return from the market even during the worse days. Since it is nearly impossible to get an idea of profitability among mutual fund players, investors could use the financials of the parent companies as a proxy. 

Nevertheless, as always, mutual fund investments are subject to market risksPlease read all scheme-related documents carefully before investing.

New to mutual fund investing? Want to learn how to pick the best mutual funds? Then, check out our online course- Investing in Mutual Funds? A Beginner’s Course. Enroll now and start your journey in the exciting world of mutual fund investing today. #HappyInvesting.

divergence analysis toolkit

What Drives Stock Returns? (Divergence Analysis)

What Drives Stock Returns? (Divergence Analysis)

Two friends- Rajesh and Suresh, were returning home after a long and tiring day at work.

Rajesh, who happened to be an active investor in the market, turned to Suresh and exclaimed “Avanti Feeds share price has fallen down so much in the last 6 months, it destroyed all the gains it has generated in the last one year. How could this happen?”.

Suresh, a calm and a seasoned investor, who has seen multiple market cycle– listened patiently to Rajesh’s rants but kept reading his novel.

Perplexed by Suresh’s lack of response to his situation Rajesh asked “How can you remain so calm in this market, Suresh? Hasn’t the contagion affected the stocks in your portfolio too?”.

Seeing that he could no longer escape the onslaught Suresh replied– “Yes Rajesh, stocks in my portfolio have also been affected by the ongoing contagion… But I don’t bother much about that because I stayed away from the markets when it was reaching premium valuations. The contagion effect has had only a mild effect on my portfolio.

*********

How many of us have been able to remain calm during the market volatility that we have witnessed in the last six months? Why is it so hard to remain stay put with our investments even when we had high conviction when we invested in them a couple of years ago? 

In fact, what causes the price of a stock to change so drastically? And what can we, as investors, do to prepare ourselves for it? This is exactly what we seek to address in today’s post.

We shall try to understand the various components of stock returns. How each divergence between the components can be used to gain a broader understanding of the market as well as the expectations placed on the script by other investors.

The topics for this post are as below:

  1. What are the components of stock returns?
  2. How do the different components affect the share price?
  3. Could the divergence be used to explain how the mood swings in the market? 
  4. What time period should be used for the divergence analysis?

This is going to a little longer post. But it will be worth reading. So, let’s get started.

Finding Stock Returns Using Divergence Analysis Toolkit:

1. What are the components of stock returns?

Everybody knows that the value of a company is driven by the underlying growth in its earnings.

But, the prices of a stock don’t just depend on the performance of the company. It also depends on the expectations of the investors and the underlying mood regarding the broader economy.

If we were to bring out an actual formula for stock price return for a company it would look something like this –>

Total Return =  Fundamental Return + Speculative Return + Dividend Return + Inflation in the Country

2. How do the different components affect the share price?

The dividend returns are a small component of the overall return achieved from a stock. If the company gives a very little or no dividend, then this component is literally doled out by the company.

The inflation return, however, happens to the black box. But, for growing economy like India, it suffices to take the inflation returns close to 5%.

Now, this brings us to the remaining two components of the equation. The Fundamental Return and the Speculative Return. From empirical evidence, it is has been broadly understood that close to 80 percent of stock returns occur just from these two components.

In a bull market, the speculative return goes over and above the fundamental return. While in the bear market the speculative return goes well below the fundamental return.

Let’s understand this from the example of Avanti Feeds. It was a hot stock in 2017, which means that it was basically a recipe for portfolio disaster.

avanti feeds share price

(Source: TradingView)

For simplicity of calculation let’s assume only the role played by fundamental and speculative return components in our equation.

Total Return =  Fundamental Return + Speculative Return

This equation could also be represented as,

Speculative Return = Total Return –  Fundamental Return

From financial and the stock price data we have created the following chart for our analysis:

Year* Mar-14 Mar-15 Mar-16 Mar-17 Mar-18 Aug-18
Stock Price (Rs) 49.5 102.5 131.8 239.2 732.6 426.9
Stock return (%) 0.0 106.9 28.7 81.4 206.3 -41.7
Profit (cr) 70.0 116.0 158.0 216.0 446.0 408.0
Fundamental Return (%) 0.0 65.7 36.2 36.7 106.5 -8.5
Speculative Return (%) 0.0 41.2 -7.5 44.7 99.8 -33.2

divergence analysis stock returns

*(Chart and table are scaled to show the returns starting from March 2014 and adjusted for stock splits and bonus issues. All financial data are shown on the preceding 12 months basis.)

From the above analysis, it becomes clear that whenever the overall stock returns exceed the fundamental returns produced by the company– the stock prices have seen a correction to the true levels denoted by the fundamentals.

3. Could the return divergence be used to explain how the mood swings in the market?

And is it really possible to time the market?

If the above analysis were to be repeated for every single company in the broader market indices, it could give a pretty good idea regarding the ebb and flow of investors’ money into and out of the market.

A possible combination of the PE multiples for the indices with the divergence analysis could be better used to indicate the overvalued/undervalued status of the market. And this may serve as a leading indicator for bull runs and market crashes.

Also read: Investment vs Speculation: What you need to know?

4. What time period should be used for the divergence analysis?

Since most market cycles last around 5-7 years, we at tradebrains, believe that it suffices to use 5-7 years of data for performing the divergence analysis.

But since a lot of stock splits and bonus issues take place in the markets every year, investors should account for these events in their analysis and use only price data that has been adjusted for these special events.

Closing Thoughts

The financial market, despite on a core level is powered by the fundamental returns generated by a company, it tends to fluctuate wildly from the fundamentals due to cycles of greed and fear that are chained to money investors put into the capital markets.

The divergence analysis can be used in this scenario to understand the cycles and be used as an indicator to make key capital allocation decisions on whether to keep away from the markets or build cash or sell your existing stock positions.

We hope you enjoyed this read, looking forward to your comments. Happy Investing.

Internal Rate of Return (IRR)

What is Internal Rate of Return (IRR)? And How Does it Works?

What is the Internal Rate of Return (IRR)? And How Does it Works?

Hi readers. A lot has been covered in our blog since inception, we have written articles ranging from the basics of financial statements to concepts of valuation. A reader who has followed our blog from the beginning should now be able to perform a detailed analysis of a company and arrive at a valuation for investment.

To our ever growing list of posts, today we shall add one that seeks to provide a method for calculating the rate of return of a portfolio. This method is called as Internal Rate of Return (IRR).

The IRR method to measure the portfolio performance has become a lot popular in recent days because of its effectiveness over CAGR measurements. That’s why you need to get acquainted with what actually is IRR and how to quickly calculate it.

The topics we shall read about in today’s post are as follows.

  1. What is the Internal Rate of Return (IRR)?
  2. How is IRR different from CAGR and how is it more useful?
  3. Application of IRR method of return calculation with an example.

It’s going to be a very informative post. So, let’s get started.

1. What is the Internal Rate of Return (IRR)?

Theoretically speaking, IRR is the rate at which the net cash flows (both inflow as well as outflow) from an investment would be equal to zero. Better said, it is the rate of return to be achieved by all the money invested to give back all the cash received.

2. How is IRR different from CAGR and how is it more useful for investors?

Although CAGR is a classic investment metric for calculating investment returns and makes a better representation of performance than average returns since it assumes the investment capital to be compounded over time.

But it makes a couple of assumptions which may hinder its practical use. Firstly, it assumes that the compounding process is a smooth one over time with steady returns being made every year. Secondly, it assumes that a portfolio incurs cashflow only two times during its lifetime. One at the very beginning when an investment is made and the second when the investment is sold and cash is returned to the investor.

In practice rarely do we come across such scenarios where an investment is made only once, most of us happen to make regular investments over time and hence the overall return may actually be different than what the CAGR method of calculation may usually project it to be.

In such cases of multiple or uneven investment periods and cash flows, the CAGR method of calculation becomes futile and using the Internal Rate of Return method would better serve the purpose. Mathematically, the IRR calculation is represented by the following expression.

Where P0, P1, . . . Pn equals the cash flows in periods 1, 2, . . . n, respectively; And, IRR equals the investment’s internal rate of return.

Also read: How to perform the Relative Valuation of stocks?

3. Application of IRR method of return calculation with an example.

Assume we bought a stock ₹3,00,000. Also, assume that we bought an additional ₹1,00,000 worth of stock one year later and another ₹50,000 in the two years later.

Let us make one more assumption that we hold the stock for 2 more years before selling the stock for a total cash return of ₹7,50,000

Here is how the IRR equation looks in this scenario:

Internal Rate of Return example

Mathematically speaking IRR cannot be computed analytically, but thanks to calculators and spreadsheets today this task can be done fairly easily.

Using the XIRR function in an excel we get the IRR for this scenario as 11.80%, which is the rate that makes the present value of the investment’s cash flows equal to zero.

If we were to calculate the CAGR for the example for an initial investment of ₹4,50,000 and final cash return of ₹7,50,000 over a period of 5 years we would get a but the incorrect return of 10.8%.

Quick Note: If you want to learn how to perform fundamental analysis of stocks from scratch, feel free to check out this online course- HOW TO PICK WINNING STOCKS. Enroll now and start your journey is the Indian stock market today!!

Closing thoughts

Although initially, the IRR method found applications in the capital budgeting projects of companies, recently it has become a favored method among investors to calculate the capital allocation efficiency of their portfolio.

We advise our readers to add this to their ever-growing investing toolkit. Happy Investing.

credit score

Everything You Need to Know About Your Credit Score.

Hello readers. Many a time, you might have heard that you should keep a high credit score. You should not default that EMI or else it will hurt your credit score.

An obvious question that may come to your mind is what actually is a credit score?  How are they measured? Moreover, why should you care whether your credit score is high?

Today, we shall be covering this hot topic in personal finance which we believe is central to addressing the financial health of any individual.

The topics we shall be covering are as follows:

  1. What is a credit score?
  2. Why is credit score important to you?
  3. How is credit score measured?
  4. Where can you get your credit report?
  5. How can you improve your score and how long does it take?

This is going to be a very interesting post, especially for the youngsters. Therefore, let’s get started.

1. What is a credit score?

Credit score is a metric used by banks and lenders to provide a comprehensive risk profile of a borrower. It is provided by four companies in India namely TransUnion CIBIL, Equifax, Experian and Highmark. The most popular agency of this being TransUnion CIBIL which provides the fabled CIBIL score.

The score is basically a reflection of your monetary habits derived from your transaction history upto three years which banks give these agencies periodically.

Also read:

2. Why is credit score important to you?

Every time you approach a bank for a loan or credit card, the bank tries to gauge the risk that comes along with your loan application. Gone are the days when your branch manager used to engage you in a long and mundane conversation asking about everything from your family background to your parents’ monthly pension before sanctioning the loan you asked for. Nowadays, they just send a mail to the credit agencies asking them for your credit score.

Upon receiving this request, the credit agencies aggregate your transaction data from multiple banks to ratify your profile into a scale of 300-900 to give a simple quantified data point for banks to make a judgment. After analyzing your score, the banks decide whether to accept or reject the application for the new credit card or loan, period.

The score bands used by banks for making an inference about your risk profile are as below

Credit score band Rating Comments
800-900 Excellent You have done great work on your score, make sure it doesn’t dip.
700-800 Good You most likely a couple of hiccups in your payments but that shouldn’t stop banks from rejecting your applications. You could improve your score through minor improvements
500-700 Average Although you may not be able to get loans immediately. You could improve your score within a matter of 2-3 months through planned action.
300-500 Poor You have several missed payments and defaults. Most banks would reject you right away.

Credit-Score-Range

Since a lot of things in life is unpredictable like the occurrence of disease or death of a family member, it would be beneficial to keep a healthy credit score so that one can always avail a line of credit when needed.

3. How is credit score measured?

The credit score may vary slightly due to the difference of calculation between each of the credit agencies but they more or less look at the same things to arrive at your score.

The following are the different parameters the credit agencies use to judge your score along with the weightage attributed to each of them.

Parameter Weightage
Credit History 30%
Credit Utilisation 25%
Credit Mix and Duration 25%
Other Factors 20%

Credit History: This is the most important factor in determining one’s credit score. The agencies look at one’s loan repayment data provided by the banks complete with the loan schedules, EMIs, late payments, and outstanding loans.

Credit Utilisation: This basically the percentage of loan one has outstanding to the total loan amount that can be availed. Ideally lower the loan one has outstanding the higher one’s score.

Credit mix and duration: The type of loan you avail also has a bearing on this aspect of one’s credit score, a higher amount of unsecured loan could lower credit score faster than an equivalent amount of secured loans. The reason for this being that secured loans are backed by property or any other asset that the bank can claim in case of default making it less risky than an unsecured loan.

Other factors: These include miscellaneous activities such as the number of hard inquiries made at the bank for loans and credit card applications. The banks often construe this as a sign of a person being under financial stress. This may have a negative impact on the credit score.

4. How can you get your Credit Report?

As per the RBI directive in 2016, every customer is entitled to one free report from each of the credit agencies in a twelve month period. This means that you can get a total of four credit reports from all agencies together. We at Trade Brains advise that our readers avail this every quarter or at least semi-annually from different credit agencies.

You can avail your reports from the websites of the four credit agencies.  (TransUnion CIBIL, Equifax,  Experian, Highmark)

It is advisable that you don’t use a third-party website to obtain your credit reports since your confidential information could be stored by them.

5. How can you improve your score and how long does it take?

A seven-point roadmap to improving your score can be as shown below:

  1. Make all your EMI payments on time and close your outstanding debt as soon as possible
  2. Avoid making unnecessary credit limit extension or loan applications
  3. Reduce unsecured loans such as credit card loans and personal loans and pay them out as soon as possible
  4. Try to keep surplus cash in your accounts so that you can avoid the use of a credit card
  5. Keep checking your credit report for mistakes, if you spot them to take it up with your agency
  6. Avoid accepting settlements for your loans from banks even though your dues may be reduced significantly. The banks report this to credit agency which adversely affects your score
  7. Avoid being co-signee or a guarantor to friends or family who tend to habitually make late payments on their loans.

We believe that if you follow these steps, you should witness your score improve within the duration of three months to a year depending on your past scores.

Also read: #11 Best Passive Ways to Make Money While You Sleep.

Bottom line

Credit Score is the most important metrics banks and financial institutions use to gauge your risk profile. It would be beneficial for an individual to maintain a high credit score so that they can avail a line of credit in times of need.

Although not easy, a credit score can always be improved through planned and disciplined action on the side of an individual. We at Trade Brains hope our readers make the best efforts to maintain a high credit score.

how to measure your investment performance

How to Measure Your Investment Performance? The Right Way.

How to measure your investment performance? -The Right Way

Hello Readers. Honestly, we at Trade Brains love cricket!. We also happen to love following the latest records and comparing statistics of our favorite players. Which of our players are the most consistent? Who is more likely to score runs and how often? Who plays better against spinners? And who works best on a flat pitch?

Well, these are just some of the questions that we keep asking ourselves right?

This got us thinking, is there anyway, we as investors, could borrow from the sport and rate ourselves? And can we make ourselves as better investors through a defined process? After all, introspection is the best critic we have on our side right?

In this post, we will be covering the different metrics and techniques, we as investors, can use to measure our performance and hopefully identify and strengthen the weak spots in our investment process. An over the top view of the toolkit is as follows:

  1. Hit-rate
  2. Slugging rate
  3. Holding Periods
  4. Performance relative to the benchmark

Overall, this post will give the best ever solution to measure your investment performance. So, without wasting any further time, let’s get started.

How to Measure Your Investment Performance?

Here are the four best and easy metrics that you can use to measure your investment performance over the years in a right way.

1. Hit Rate

Broadly defined, hit rate is the percentage of profitable investments to the total number of attempted investments.

hit rate- How to Measure Your Investment Performance

The keyword in this metric is “attempted investments”. Many a time, retail investors do more harm than good to their portfolios by investing in stocks they do not understand in an attempt to diversify their portfolio. This approach could result in below market performance for the investors in the long run. A better approach would be to make infrequent but highly probably bets in the market.

This sentiment is also paraphrased by master investor Warren Buffett through one of his famous analogies comparing investment performance to playing baseball.

“What’s nice about investing is you don’t have to swing at pitches. You can watch pitches come in one inch above or one inch below your navel and you don’t have to swing. No umpire is going to call you out. You can wait for the pitch you want. In investing, just as in baseball, to put runs on the scoreboard one must watch the playing field, not the scoreboard. I’ve never swung at a ball while it’s still in the pitcher’s glove.”

– Warren Buffett

Also read: Why You Should Invest Inside Your- Circle of Competence?

2. Slugging Rate

Quite simply this is a measure of how much you profit when you win and how much loss you incur when you don’t.

slugging rate -How to Measure Your Investment Performance

Logically, any investor who wishes to make positive returns will have to ensure that their gains outdo their losses. The more the outperformance of the gains the better the returns will be for the overall portfolio.

Also read:

3. Holding Period

Although most investors think they need not use this statistic to measure their performance, we at Trade Brains, believe otherwise.

Ideally, you as an investor would want to hold on to your winning picks and exit your losing stocks quickly. While, this doesn’t mean that you drop a stock just because it went down immediately after you bought the stock, a stock that drops 40-50% should be treated as a red flag and reviewed before taking a decision on whether to continue holding the stock or not.

4. Performance relative to the market benchmarks

Since most investors seek to beat the market over time, it would make sense to measure your portfolio’s performance against broader market indices such as NSE Nifty 50 or BSE Sensex.

The performance relative to the market indices can help you decide whether you need to increase your exposure to mutual funds or stop investing on your own entirely.

For a portfolio composed of predominantly large-cap stocks, it would make sense to compare the portfolio relative to large-cap indices (and similarly for mid-cap and small-caps).

But what if your portfolio had exposure to large, mid and small cap segments of the market?

Let us understand the method of evaluation through the following example.

Assume that an investor has 30% exposure to large-cap stocks, 30% to mid-cap and 40% to small-cap stocks.

The best method for evaluating such a scenario would be to take the weighted average returns of indices to measure one’s portfolio performance.

Market Segment Market Index 3-year return Portfolio exposure
Large Cap BSE Sensex 54.20% 30.0%
Mid Cap BSE Mid Cap 62.90% 30.0%
Small Cap BSE Small Cap 62.2% 40.0%

The weighted average returns of the indices for a similar market exposure as the portfolio will be given by the following expression-

Weighted Average returns for 3 Years = [(large cap exposure x large-cap index return) + (mid-cap exposure x mid-cap return) + (small-cap exposure x small-cap return)] x100

= [(30.0% x 54.20%) + (30.0 %x 62.90%) + (40.0% x 62.2%)] x 100

= [0.1626 +0.1887+0.2488]x100

= 60.01%

If the investor’s portfolio achieved returns greater than the 60.01% in three years (that would have been achieved by a similar exposure to the market benchmarks), then it is best for him to continue investing on his own. Otherwise, it would be better for the investor to allocate his capital to Index Funds with similar weighting or change his/her investing strategy.

Closing thoughts

The financial markets are fantastic yet dangerous places to grow your wealth over a lifetime. Any investor who wishes to play the game for the long term will have to continuously adapt their investing process to achieve the most optimum returns.

We hope our readers will add the above methods to their toolkit for measuring portfolio performance. Happy investing.

moat analysis framework

How to Check if a Moat Exist? Use Moat Analysis Framework.

How to Check if a Moat Exist? Use the Moat Analysis Framework.

It is quite strange that a medieval defense strategy employed in the fortifications of forts in England has come to occupy such a central stage in value investing stock analysis.

Come to think of it, if you could picture England as a giant castle and The English Channel as the surrounding moat, you could quickly deduce that once England united the other nations on its island there would be few world powers who could launch massive territorial conquest on its shores especially since amphibious operations always tend to favour the defending side. (Perhaps this enabled them to  expand their empire since not much needed to be done on homeland security front).

As explained in our posts before, Moats are long-lasting competitive advantages a company might have owing to its business model that enable it to resist the onslaught of competition for a great number of years.

Also read: What is an Economic MOAT and Why it’s Worth Investigating?

The evolution of Moat:

In the period around 1950-1960, when great companies such as Walmart and Nike were still startups, the greatest struggle the entrepreneurs faced was the problem of securing a starting capital. Most of the times business in that time had to open a line of credit from banks but the problem was that the banks were highly regulated and only were willing to lend to those companies which had already established their operations and achieved some reasonable scale to their businesses. This gave an advantage to existing businesses since the system stifled the growth and emergence of new competitors.

Come the 70s, the world began to see the rise of venture capital and private equity firms namely Sequoia and Carlyle in the US. These companies were able to pool in money from investors and redirect them to fund the capital of emerging entrepreneurs of Silicon Valley and elsewhere.

In time (that is the last 4 decades), the high capital requirement as a barrier to entry has steadily eroded away and have enabled upstarts and disruptors to challenge incumbent businesses across different sectors.

The other trend (which will get even more relevant in the future) has been the evolution of technology at breakneck speed which has fundamentally brought down the cost of entry into many businesses at the cost of well-established firms.

Since companies face a greater risk to their business models now more than ever, it has become imperative for investors to select the companies with the most resilient business models for their portfolio. Only then it is possible for investors to generate steady returns without painful volatility.

The process of finding moats can be quite arduous and confusing for investors who are starting out, especially when a lot of companies seem to be running profitable operations for extended periods even without any apparent moat. Although moats often come in various forms and sizes, it may sometimes be very difficult to identify and to judge their quality for many companies. In such a scenario it helps to have a decision-making framework to act as a force multiplier in the investor’s toolkit.

Also read: SWOT Analysis for Stocks: A Simple Yet Effective Study Tool.

Moat Analysis Framework

The following moat analysis framework should provide a good starting point for our readers in their analysis. You may feel free to develop this into a more comprehensive and robust framework based on your experiences and understanding of different industrial sectors.

(Please note the framework was developed by Ensemble Capital, an asset management company in the US, it draws greatly from the experiences of the firm’s analysts and books including “The little book that builds wealth” by Pat Dorsey and The Investment Checklist by Michael Shearn)

moat analysis framework

(Source: Intrinsic Investing)

enterprise value and equity value examples

A Complete Guide on Enterprise Value and Equity Value.

Enterprise Value and Equity Value are two terms that have confused investors and sometimes professionals alike through the years. In this post, I shall try to clear some air on both the terms and help our readers figure out the one they need to use during their analysis of companies.

Here are the topics that we will cover in this post:

  1. Who are the different stakeholders in a firm?
  2. What is the level of risk associated with the level of ownership?
  3. What is Enterprise Value and Equity Value and how are they calculated?
  4. Enterprise Value and Equity Value Multiples
  5. Methods of analysis using Enterprise Value and Equity Value
  6. Closing thoughts

On a broad level, this will be long, but an easy read and we would really appreciate that our readers leave comments in case of any doubts.

1. Who are the different stakeholders in a firm?

To understand the concept of Enterprise Value and Equity Value, it would first be necessary to understand the different players in the capital markets and their claims on a company’s capital and income.

To understand this, picture a company like a big country with different religious and social groups with each group seeking to pursue their own interest but somehow still manage to operate under the common banner of a company.

These interest groups from the perspective of a company include those who have contributed capital to the firm. Since a company can generate capital from debt and equity the top-level classification of the mentioned interest groups comprises of Debt Holders and Equity Holders

Note that the two groups can be further divided into subgroups depending on the priorities of each subgroup.

Also read: Shareholding Pattern- Things that you need to know

2. What is the level of risk and return associated with the level of ownership?

In corporate finance, when an asset is sold the debt holders get a priority to the funds generated from the sale and then the different classes of equity holders.

Since debt holders normally take fixed payments at the regular periods regardless of the profit-generating capacity of a company, their position tends to be the one of minimum risk in the company’s capital structure.

The equity holders, on the other hand, get dividends only when the company makes a profit (in most cases) and also happen to pledge their money as owners of the firm without the promise of returns. This makes their position the riskiest within the capital structure.

The below infographic should summarise the relationship between capital and relevant risk and payments for different equity and debt holders.

Enterprise Value and Equity Value 1

3. What is Enterprise Value and Equity Value and how are they calculated?

Now to address the crux of this post, assume that a big financial investor wants to buy a company. Let us say he wants to get 100% control of the firm and also 100% of the earnings generated by the firm.

To achieve the first goal, he would just have to buy the stakes of equity holders of the firm, these equity holders could include the Minority Interest, the Preferred Shareholders, and the Common Shareholders. The money the buyer would have to expend to acquire the complete equity of all the above-mentioned groups is what is known as the Equity Value.

Now since the equity holders are of the picture, the buyer now turns his eyes towards the debt holders. To make the debt holders give up claims to the company’s earnings (in the form of interest and principal payments), our buyer would have to pay them cash equivalent to the debt they hold in the company. A lot of the times, the buyers use the cash and cash equivalents of the company they bought to pay off the debt outstanding on the balance sheet. In finance, the term used for the is called the Net Debt.

Net Debt = Total Debt – Cash and Cash Equivalents

And further, the formula for Enterprise value becomes

Enterprise value = Equity Value + Net Debt

Enterprise Value and Equity Value 2

Assuming the company has also got minority interest, preferred shareholders and affiliates/associates the formula gets modified as

Enterprise Value  = Equity Value + Preferred Shares + Minority Interests – Value of Associates + Net debt

4. What are the Enterprise Value and Equity Value multiples?

The key difference between Enterprise Value and Equity Value is the inclusion of the Net Debt figure in the calculation. So when we think of multiples only terms which have the payments related to debt (interest) should be included with Enterprise Value and the metrics devoid of debt payments (interest) should be included with Equity Value.

The following figure should give the summary of the financial statement components used with both Enterprise Value and Equity Value.

As mentioned earlier, please note in the income statement that all metrics which include interest is included with the Enterprise Value calculation.

Enterprise Value and Equity Value 3

The corresponding ratios are summarised in the following figure

Enterprise Value and Equity Value 4

5. Methods of analysis using Enterprise Value and Equity Value

The multiples of Enterprise Value and Equity Value can be used extensively in the valuation analysis of a company. The two methods of valuation that are commonly used are relative valuation and historical valuation.

The limitation of using the relative valuation method is that during the period of elevated valuations- during a bull market all our comparable companies may be trading at a premium, this may sometimes make our target company seem cheap when it is only less expensive.

Similarly, during periods of depressed valuations, our target company may look expensive compared to our comparables when it is actually only slightly less cheap.

Also read: Why Warren Buffet Suggests- ‘Price Is What You Pay, Value Is What You Get’?

6. Closing thoughts

Although a lot of retail investors do not use Enterprise Value multiples in their valuations to could be useful to do so since the resulting valuations are inclusive of the leverage the companies have employed in their business activities.

In case retail investors find the concept of Enterprise value confusing, it should not deter them from performing a good analysis of companies if they use other leverage evaluation methods in their research and analysis process.

We hope our readers continue to embrace an objective approach to their valuation processes while performing stringent quality checks on the stocks they invest in. Happy Investing.

How to use Treasury Stock Method to Calculate Diluted Share stocks

How to use Treasury Stock Method to Calculate Diluted Shares?

How to use the Treasury Stock Method to Calculate Diluted Shares?

Hi Investors. We earlier published an article detailing how dilution affects our ownership position in the company and how it affects the calculations for PE ratio and Earnings Yield ( 1/ PE). (You can read that article here: How Dilution Affects the Company’s Valuation?)

In this post, we will cover how employee stock options are converted into common stock and learn how to calculate the incremental contribution to a number of outstanding shares (NOSH). 

Here are the topics that we will discuss today:

  1. Why stock options?
  2. What is the common term associated with stock options?
  3. Main kinds of stock options given to employees and management?
  4. What is the treasury stock method and why is it called so?
  5. Closing thoughts – the good, the bad and the ugly

It’s going to a little lengthier post. However, it will definitely be worth reading if you want to learn the dilution basics. So, let’s get started.

1. Why stock options?

Companies are increasingly rewarding their employees using stock options this provides multiple benefits:

  1. It helps align the management actions in line with the interests of the shareholders or better said managers of a business become shareholders themselves and are rewarded when their decisions in the operating activities deliver value to the shareholders
  2. Employees and managers who are rewarded stock options get the twin benefit of capital appreciation of the stock in the market and also of the lower capital gains tax for investments held over the period of 1 year.

2. What are the common terms associated with stock options?

Although there are a lot of terms we may come across when we read about stock options, almost always it will suffice to know just the meaning and relevance of a handful of terms when assessing options. Some of the most relevant that we feel will be useful for our readers are as follows:

  • Issue date: this corresponds to the date on which the underlying stock option was issued to the holder
  • Exercise date: represents the date on which the holder of the stock gains the right to exercise the option
  • Exercise price: represents the minimum price required to be attained by the shares of the company before the options can be converted into common stocks
  • Vested and non-vested shares: When a stock option is owned by an individual and he/she retains the right to exercise them when they wish so, the option is said to be vested. Non-vested shares options, on the other hand, represent those which are still owned by the company and the transfer of ownership to the individual hasn’t occurred yet.
  • In-the-money / out-the-money: When the trading price of a stock above the exercise price of the option is then said to be the in-the-money option, while it is said to out-the-money when the share price is below the exercise price (and then rendering the exercising such options useless).

3. What are the main kinds of stock options given to employees and management?

In most annual reports investors may come across different types of stock options, the common ones are (but not limited to) ESOPs or employee stock options, Restricted Stock Units (RSUs), Performance Stock Units (PSUs).

Employee Stock Options (ESOPs)

In almost all cases these represent the options offered to individuals by companies as a part of their equity compensation plans. These are usually reported by companies with relevant details like issue date, exercise date, the and exercise price. The primary catch for the employees here is that their options do not become exercisable unless and until the stock price of the company trades above the mentioned exercise price

Restricted Stock Shares (RSSs)

These are awards that entitle individuals to ownership rights to a company’s stock. Normally, these are subject to restrictions with regard to the sale of the stock or option until they become vested. The vesting event is determined by minimum service or performance conditions set by the company for the employee. However, during the restricted period, the individuals may have voting rights and the right to the dividends owed to restricted shares.

Performance Stock Shares (PSSs)

Performance Stock Shares are restricted stock shares that vest upon the achievement of performance conditions specified by the company. These shares are generally subject to sale restrictions and/or risk of forfeiture until a specific performance measurement is satisfied. Performance measurements are set by your company. During the restricted period you may have voting rights and the right to dividends paid on the restricted shares, which may be paid to you in cash or may be reinvested in additional performance shares. Once vested, the performance shares are usually no longer subject to restriction.

Also read: #19 Most Important Financial Ratios for Investors

4. What is the treasury stock method and why is it called so?

The most commonly used method within the finance industry to calculate the net additional shares (from exercising the in-the-money options and warrants) is the treasury stock method (TSM).

Here, it is important to note that the TSM makes an assumption that the proceeds the company receives from in-the-money option exercises are subsequently used to repurchase common shares in the market. Repurchasing those shares turns them into shares held in the company’s treasury, hence the eponymous title.

Implementing the treasury stock method

The broad assumptions in the TSM are as follows. Firstly, it assumes that the options and warrants are exercised at the start of the reporting period and that a company uses the proceeds to purchase common shares at the average market price during the period. This is clearly implied within the TSM formula.

Treasury stock method formula:

Additional shares outstanding = Shares from exercise – repurchased shares

Additional shares outstanding -Treasury stock method

Example:

Imagine a scenario where a company has an outstanding total of in-the-money options and warrants for 15,000 shares. Assume that the exercise price of each of these options is around ₹400. The average market price of the stock, however, for the reporting period is ₹550.

Assuming all the options and warrants outstanding are exercised, the company will generate 15,000 x ₹400 = ₹60,000 in proceeds. Using these proceeds, the company can buy ₹6,000,000 / ₹550 = ~10909 shares at the average market price. Thus, the net increase in shares outstanding is 15,000 – 10,909 = 4,091 shares.

This can also be found by simply using the last formula provided above. The net increase in shares outstanding is 15,000 (1 – 400/550) = 4,091.

Also read: How to read financial statements of a company?

5.Closing thought:  The Good, The Bad and The Ugly

Although options can be a force used for good as described at the beginning of this post it is not always a very innocuous tool. Since almost always, options are more complicated than cash payments there arises a potential for companies to manipulative the rewarding scheme to incentivize the management too much (beyond what is considered acceptable) at the expense of the shareholders.

Another problem can sometimes arise when a firm holds options or convertible debt offerings in another publicly traded company, there have been cases in the stock market history where such firms have gained majority control in the publicly traded company and subsequently initiated multiple activist campaigns against the management and in extreme cases have ended up owning the company entirely (a lot of the times at the expense of minority shareholders).

An argument which is sometimes overseen but nonetheless is credible when understanding options are that options incentive management to undertake risky decisions. These could sometime come in the ugly form of management cutting corners to influence the stock prices in the short term so that the options they hold may become exercisable. It is also not uncommon to see situations where management undertakes short-term risks that may eventually outweigh long-term gains for the shareholders.

In view of the above scenarios, a retail investor when assessing companies should look at the state of the options and the rewarding schemes when studying the management of their target company. Normally the two main things an investor needs to look for to be able to make a reasonably informed judgment include the following:

  1. The period for the options are awarded: here longer is better, something more than 3 years should be considered as satisfactory
  2. The number of options which are awarded: make sure that excessive amounts in addition to the existing cash packages are not paid out to the management and employees unless deserved.

That’s all for this post. I hope it was useful to the readers. Happy Investing.

Margin of Safety by Seth Klarman book review

Book Review: Margin of Safety by Seth Klarman

Hi Investors. In this post, we are going to discuss the book review of Margin of safety by Seth Klarman (Originally published in 1991).

About the Author:

Seth Andrew Klarman is an American billionaire investor and hedge fund manager.

He is a graduate of Cornell University and has a business degree from Harvard Business School. Klarman is the founder of The Baupost Group, a Boston-based private investment partnership, that focuses on making value-based investments in the US public markets (founded in 1982). 

In the recent decade, Warren Buffett and his lieutenant Charlie Munger have voiced their support for his investment style and even went on to state that Seth Klarman would be one of their asset managers of choice to manage their personal portfolios. 

Besides, Klarman is also a close follower of the investment philosophy of Benjamin Graham.

Book Review of Margin of safety by Seth Klarman:

margin of safety -seth klaarman

The Margin of Safety by Seth Klarman covers a broad spectrum from providing sound education on the psychology of investing as well as developing the quantitative and qualitative aspects of value investing. It is sometimes said to be the most important book available on value investing after The Intelligent Investor by Benjamin Graham.

The book primarily explores three broad themes for the investor:

  • Firstly the futility of the efficient model hypothesis and the practice of finance professionals of over-relying on their models and estimates.
  • Secondly, it focuses on the concept of risk and the central role it plays in investment success
  • And finally on valuation and market opportunities for the retail investors

Klarman encourages investors to always assess their investments only after first evaluating the risks associated with a particular opportunity and then and only then the potential returns.

In his eyes, the key to a successful track record in investing comes not by achieving higher than average returns but by achieving below than average losses.

This strategy has seemingly worked for him and his investment fund, they have achieved a 19% CAGR for every dollar invested in them (despite maintaining close to 20% cash position in their portfolio for most of the years)

“The avoidance of loss is the surest way to ensure a profitable outcome. Loss avoidance must be the cornerstone of your investment philosophy” – Seth Klarman

The book illustrates this concept through the example of 2 people, say A and B, who invested in the market over a period of 5 years.

Assume A generate returns of 12% for 4 years while B generated only 10%. In the 5th year, due to a market downturn, A’s portfolio witnessed a drop of 10% while B witness a drop of 5%. Because of this significant drop in the down year in A’s portfolio, B ends up having a higher portfolio return in comparison to A.

Also read:

In the book, Klarman espouses that the value investment philosophy is based on three timeless pillars:  a bottoms-up approach to selecting investments one stock at a time, absolute performance orientation that enables one to buy and hold irrespective of short-term relative non-performance and paying attention to the real risk of capital loss, not beta (volatility).

Further, in the book margin of safety by Seth Klarman, the author consistently stresses on the need to focus only on one’s own analysis and to discard the market noise when making an investment decision.

Klarman also discusses the difficulty involved in the art of valuing a business and recommends arriving at a conservative but imprecise range of business value based on 3 or 4 techniques: Net Present Value of Free Cash Flows, Liquidation or Breakup value, and Stock Market Value.

(His book provides practical examples of his philosophy, we encourage our readers to take time to go through his work to improve their knowledge and skill in valuation)

“It would be a serious mistake to think that all the facts that describe a particular investment are or could be known. Even if everything could be known about an investment, the complicating reality is that business values are not carved in stone. If you cannot be certain of value, after all, then how can you be certain that you are buying at a discount? The truth is that you cannot” – Seth Klarman

Klarman closes his masterpiece with tips for retail investors on finding opportunities in the market namely catalysts, market inefficiencies, and institutional constraints, as well as then going on to provide detailed evaluation methods for thrifts and bankruptcy situations.

Also read: 10 Must Read Books For Stock Market Investors.

Bottomline:

In our view, Margin of Safety by Seth Klarman is a must read for all investors of all levels, besides strengthening foundations on the value methodology it also provides insights into how a seasoned investor stays apart from the chaos of the market to generate stable returns. Happy Investing.

Introduction to business models Arbitrage and Retail

An Introduction to Business Models: Arbitrage and Retail.

Understanding business models – Arbitrage and retail:

Hi Investors. In this post, we will be discussing an arbitrage and how it is exploited in the retail industry. If you have previously analyzed any company in the market you would already know that among the different business models one of the easiest in terms of operation is the business of arbitrage and retail.

Today we shall go a level deeper into the analysis of a retail company and discuss one of its most important metrics and its significance. The topics we shall cover in the post are as follows:

  1. What is arbitrage?
  2. How do retailers use this strategy today?
  3. What metric should we use to analyze whether arbitrage is working out for a retailer?
  4. What is the SSS growth?
  5. How to identify the drivers behind retailers’ business model from SSS growth?
  6. How are business models changing in retail and how to modify our analysis?
  7. Conclusion

On the whole, this will be a long post- but we hope you find this very rewarding and is definitely worth reading. So let’s get rolling.

1. What is Arbitrage?

Arbitrage is a money-making strategy followed by traders since the very ancient times, even today it is sometimes thought to be an almost risk-free strategy. The aim of those traders in business was to profit from the difference in the pricing of goods between two regions or markets.

Let’s take the example of the famed Silk Road.

Traders and merchants used to travel from the Mediterranean, Persia and the Levant to Central Asia and China to buy silk and other products, then they used to travel all the way back to sell these goods in their home markets.

Silk route

Back then a commodity like silk was precious and luckily for all merchants, China had a complete monopoly over the production of Silk. This made them even more precious in some markets than the others. The markets farthest and wealthiest away from the production center became the areas where the silk trade was most lucrative just like ancient Egypt, the Roman Empire, Ottoman Empire etc.

2. How do retailers use this strategy today?

Modern retailers use the same strategy of arbitrage to generate profits (they buy products from manufacturers and wholesalers for lower prices and sell them to consumers at higher prices), but of course with some tweaks.

But since competition is high in the modern landscape, retailers often tweak their business models to gain an advantage over their peers.

3. What metric should we use to analyze whether arbitrage is working out for a retailer?

As we just mentioned, retailers tweak their business models to gain competitive advantage and a lot of the times many retailers follow the same strategies. This spells trouble for us as investors, how do we know which retailer is doing the right thing and who is failing to do so?

Luckily for us, there is a metric that can help us analyze just this question. The metric is called the Same-Store-Sales growth rate.

Also read: 14 Most Frequently Asked Stock Investing Questions by Beginners.

4. What is the SSS growth?

Same-Store-Sales” as mentioned is one of the most important and useful metrics for retail companies. This metric also has other names such as “like-for-like” sales or “Comparable-Store-Sales” and “identical-store-sales”. The concept behind the metric is fairly straightforward: the metric represents the sales growth of stores which were present for more than a single financial year.

Let’s understand this through an example, assume that we operate a retail business with 10 stores spread across Maharashtra in 2016 and as part of our growth strategy we open two more stores in 2017. Let us also assume that our revenues increased by 10% during this period. This 10% growth could be broken down into the following two sub-parts

  1. Growth due to new stores opened in 2017
  2. Growth due to increased sales in existing stores at the beginning of 2017

The second sub-part: the growth from existing stores is what is represented by the SSS growth metric.

In an ideal world, we would want to make sure that our current stores are generating sales growth for many years once they are opened. This scenario will only happen only till the day our customers find value in our products and the SSS metric helps us deduce whether our business is continuing to deliver value to our customers.

5. How to identify the drivers behind retailers’ business model from SSS growth?

In economics, we all know the scenario of perfect competition. It is the market condition where every seller sells their products at the same price as their competitors and profits are marginal. Retail is a highly competitive business since anyone with a sufficient capital and basic knowledge of logistics can become set their own store up (remember the Kirana stores at the corner of your street?).

Retailers try to outdo their competitor by employing various strategies to create an intangible or a tangible value to their customers and deny or gain an advantage over their competitors.

The drivers behind SSS growth could be any combination of the following:

  1. Pricing of products: retailers try to achieve higher pricing power by creating intangible value to customers by selling branded products
  2. The volume of products sold: some retailers do not have much pricing power so they sell large quantities  at slightly discounted prices to make profits
  3. Net store productivity: retailers sometimes sell add-on products and accessories to boost the revenue per each sale that they have

Obviously, the most desirable and profitable route for a retailer would be to improve the pricing of products sold in their stores but most retailers would witness a drop in their volumes. But some company have created such strong brands that they can indefinitely increase their prices without facing a major drop in sales. Examples of these firms would be the sporting giant Adidas and the global luxury firms Tiffany and Gucci.

The second route is that of companies which focus exclusively on volumes, these are usually companies that have achieved economies of scale and can significantly underprice their competitors out of business. Because of their low pricing consumers flock to their stores for cheaper products. Examples of this type of retailers would be DMart, Amazon, Walmart etc.

(Please note here that economies of scale and brands that can charge a premium are significant economic moats for a retail and consumer companies)

The third most common route is to sell increase the products sold to a customer in a single transaction. It may be an auto-retailer who sells you a car and also an insurance scheme or maybe those leather covers on your seats. It could also be the restaurants that sell you the main course with starters and the side drink or even the furniture store from where you bought the table, the chair, and the table lamp.

6. How are business models changing in retail and how to modify our analysis?

With the advent of e-commerce retail players worldwide have witnessed dramatic headwinds in their operations and have begun to change their business models to adapt to the evolving business landscape. Increasingly retailers themselves are opening up their own e-commerce sites and selling products.

Eventually, as companies change so should our analysis techniques, in view of the above development, using the SSS metric along with the online/ e-commerce sales growth metrics to understand companies would better suit our goals.

Also read: What is an Economic MOAT and Why it’s Worth Investigating?

7. Conclusion

Retailers although reliant on arbitrage continue to adopt strategies to give an edge to their businesses. The SSS growth metric helps us identify whether the retailers are able to put theory into practice and also identify the factors driving their growth.

The SSS metric also helps us identify whether companies are able to develop credible economic moats. In companies which have both offline and online retail presence, it would be wise to incorporate online/e-commerce growth and value metrics along with SSS in our analyses. Happy investing!!

Also read: How To Select A Stock To Invest In Indian Stock Market For Consistent Returns?

How Dilution Affects the Company's Valuation

How Dilution Affects the Company’s Valuation?

Dilution of a company’s shares is a common scenario in the equity market. However, there is multiple effects on the valuation of the company in terms of market value and EPS (earning per share) calculation after dilution. In this post, we are going to discuss how dilution affects the company’s valuation.

We will be covering the following topics in the post today:

  1. What is dilution?
  2. What causes dilution?
  3. How to identify companies where dilution is likely?
  4. Calculation of shares outstanding after dilution.
  5. How dilution affects the company’s valuation?
  6. Bottom line

This is going to be a technical yet interesting post and we would advise our readers to read this carefully. Feel free to reach out to us or post comments in case of any doubts or clarifications.

1. What is dilution?

share dilution

Simply define dilution is the term used to describe the reduction in ownership or voting rights in a company.

Let’s understand this through the following example.

Assume a Company A’s equity is divided into 100 shares and we own 10 shares in the company, i.e we own 10% equity in the company. Now, let us assume that the company decided to fund its expansion plans by issuing new shares in the stock market (follow-on offerings). So, on the day of issue, the company issued 100 new shares in the market and a foreign firm with interests in the Indian market acquired all of the new shares issued.

Now, the company’s new equity is broken up into 200 shares out of which the foreign investor owns 100 shares (50% of equity) while we own 10 shares (5% of equity).

In the example, the follow-on offering is said to be dilutive for the company’s shareholders since their effective ownership has decreased in the firm.

Also read: Shareholding Pattern- Things that you need to know

2. What causes dilution?

Dilution can happen due to various some of the reasons are given below (may not be an exhaustive list)

  1. Follow-on offerings in capital markets
  2. Conversion of options and warrants by the holders
  3. Conversion of convertible bonds into equity
  4. Offerings of new shares to partners during acquisition or Joint-Ventures

3. How to identify companies where dilution is likely?

In most cases dilution happens when the company has desperate needs for infusing capital into its operations. Since modern financial ecosystem provides multiples routes and opportunities to achieve this aim, the most common strategies used by companies are to raise capital through debt offerings or through the issuance of new shares in the secondary public markets.

In case the company raises money through debt, this route need not always result in dilution of equity holdings for the investors. Dilution through debt happens only in case the company pledges to give its equity as collateral for a certain amount of debt.

Also read: How to Find the Shareholding Pattern of a Company?

4. How to calculate the shares outstanding after dilution for calculating market cap?

The shares outstanding after dilution would simply be as per the following equation,

Total dil. shares outstanding = common shares +newly issued shares

where, the newly issued shares could primarily come from (but not limited to) conversion of convertible preferred shares, conversion of convertible debt and also from shares issuable from stock options

This is shown by the following expression,

Newly issued shares
= shares from conversion of conv. preferred shares + convertible debt + issue of stock options

The calculation of the new shares from convertible preferred shares and convertible debt are pretty straightforward since most of the time these shares and debt are issued at a fixed conversion rate.

For example, Assume a Company ABC has issued 1000 preferred shares and 50,000 convertible bonds amounting ₹50 Lakh in debt. Also, the company on the date of issue stated that each of the 10 shares of preferred shares could be converted for 1 common share and 5,000 of the bonds could be converted for 100 common shares.

The newly issued shares post-dilution would be the sum of 100 (from preferred shares) and 1,000 (from convertible bonds) which is equal to 1,100 new shares.

(The shares issued from stock options is slightly complicated and is usually calculated using the treasury stock method. We shall review this method in another post.)

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5. How dilution affects the company’s valuation?

Dilution affects the company’s valuation of terms of its different calculations. Here’s how dilution impacts the company’s market value and eps calculation-

Market Value

Due to the rise in the total number of shares outstanding after the dilution, Market Value may change significantly after dilution, depending on the extent of the dilutive effect of the newly issued shares.

The formula for calculating Market Value remains the same, except that we will now use.

Total Diluted Shares Outstanding instead of Total Common Shares Outstanding.

Market Value = Price per share Total Diluted Shares Outstanding

Earnings per share

The impact on earnings per share due to dilution is may become quite profound depending on the extent of dilution and is very important since EPS is very commonly used by investors in the final calculation of the intrinsic value of a stock.

Since companies normally get a tax benefit for interest paid on debt, after dilution this benefit is no longer applicable and we may see our net income being boosted by the after-tax amount of debt.

Another change that happens is due to dilution of the convertible preferred shares, in case the preferred shareholders were paid the dividend out of the net income of the company earlier, they need be paid anymore after dilution since they have the same status and rank as the common equity holders in the company. The change in the formula due to the dilution is illustrated by the following expressions,

The basic EPS of a company is given by the following formula,

The diluted EPS of a company is using from the below formula,

diluted eps

Also read: #19 Most Important Financial Ratios for Investors

Bottom line

In this post. we understood the impact of dilution on the valuation with the help of equity dilution example. Today, we learned that dilution can have a significant impact on the Market Value and EPS calculations of a company and may distort the true value if it is not incorporated during the analysis of a company. 

Since dilution mostly comes at the expense of the common investor, we advise that our readers scrutinize the annual report to find whether dilution is good or bad for them. A careful look at the financial statements is required to make the necessary changes during dilution analysis. Afterall, a decrease in the existing shareholder’s ownership in a company also means a decreased profits. 

That’s all for this post. I hope this is helpful to the readers. Happy Investing.

Dupont Analysis - A powerful tool to analyze companies

Dupont Analysis: A powerful tool to analyze companies.

How to incorporate the Dupont analysis while researching stocks?

As investors in the stock markets, it is important to find high-quality along with fairly valued companies to invest our capital. The rationale behind this is simple. Our aim in the markets is to always preserve our capital first and then produce profits.

There are several robust tools that investors use during their stock analysis.

In this post, we will make an attempt to share one such powerful framework to assess the quality of stocks that we target for our portfolio -The Dupont Analysis.

The topics we shall aim to cover are as follows-

  1. What is the DuPont Analysis? Who made it?
  2. The technical background of the DuPont Analysis.
  3. Real world DuPont Analysis of Eicher Motors
  4. Conclusions

The post should be an easy read and we hope our readers find this to be of great value to their time. Feel free to reach out to us or post comments in case of any doubts or clarifications.

1. What is the DuPont Analysis? Who made it?

DuPont analysis was created around the 1920s by Donaldson Brown of Dupont Corporation. Initially, when Brown invented the framework it was used for assessing the managerial efficiency of the company before it got adopted by public market investors. His genius was breaking down the formula for Return on Equity (ROE) into its constituent parts to analyze the root cause of ROE.

2. The technical background of the DuPont Analysis

Breaking ROE into its constituents helps us investors analyze the company’s business model and how it manages to achieve excess returns for its shareholders.

Since most investors (including Warren Buffett) use ROE to judge the quality of a stock it would be of great use to us to understand how deep “Quality” actually runs within the business.

To understand how the analysis technique is used let’s start with the very basics. As most of us already know, Return on Equity (ROE) is calculated from the following formula –

ROE formula

Now, our friend Brown brown multiplied and divided the expression to get the following–

DuPont Analysis 1

This expression is now also summarised as below-

DuPont Analysis 2

But Brown did not stop there, he took this expression and went one step further. This time he multiplied and divided the expression with Total Assets to give us the DuPont formula-

DuPont Analysis 3

Which is again summarised as,

DuPont Analysis 4

From the last expression, it becomes clear that ROE is not merely a ratio (as per the formula we started with) but a framework to understand the business and capital position of the company as a whole.

Valuable insights can be derived from knowing which of the attributes drives the rise or deterioration of ROE over a period of time.

It can also be used to compare companies with their peer sets to get a deeper understanding of the differences in the business models between the companies.

Also read: How to read financial statements of a company?

3. Real world DuPont Analysis on Eicher Motors:

Let us perform the DuPont analysis on Eicher motors for the period 2014-2018.

The summary table and the evolution of the three attributes from the analysis is as given below.

Financial Ratio 2014 2015 2016 2017 2018 Net Effect
ROE 19.2 24.5 31.3 31.2 27.9 Increased
Net Profit Margin 5.8 7.0 21.9 23.7 21.9 Increased
Asset Turnover 203.3 222.4 105.5 100.3 94.1 Decreased
Leverage Ratio 162.9 156.2 135.2 131.1 135.5 Decreased

From the table, we can see that the company has improved its ROE from 19.2% to 27.9% in 5 reporting periods.

We can also see that the company decreased its leverage and asset turnover but this drop was offset by close to 3.7 times rise in the net profit margins.

Further, notice that the leverage ratio has been stable since 2016 while asset turnover has seen a drop in 2015-2016 and then moderate decreases from 2016-2018.

This analysis can now set the foundation for further analysis, the questions raised from the above figures could be as below ( this may not be very exhaustive but may give an idea as to how the framework is used)-

  1. What is causing the decrease in asset turnovers? Is it because of rising inventory? A fall in efficiency? Or perhaps a decrease in capacity utilisations at manufacturing facilities?
  2. Is the Net Profit Margins led by rise in prices or decrease in costs of goods sold?
  3. What caused the spike in net profits and the corresponding drop in asset turnover?

Answering the above questions in additions to questions generated by assessing the financial statements could help the investors analyze Eicher Motors in greater depth.

Also read: How To Select A Stock To Invest In Indian Stock Market For Consistent Returns?

4. Conclusion

Since ROE is used as a measure of the quality of management by many investors, the incorporation of DuPont Analysis could help quell any illusions developed by using ROE at face value.

According to DuPont formula, ROE is a function of net profit margins, asset turnover, and the leverage ratios. A rise or dip in ROE could be because of a corresponding rise/fall in any of these metrics and hence a high ROE doesn’t always indicates a better performance.

Our readers are advised to use DuPont Analysis along with the other stock evaluation frameworks and not to solely depend on data provided by the financial websites.

That’s all for this post. I hope it was helpful to you. Happy Investing!!